CMU: The dangers of trading sentiment

Cracked.Market University

All too often we hear the cynics claim the market is “too bullish”, or the optimists shout the market is “too bearish”. What they are really saying is they believe the market has gone too far in one direction and it is about to reverse. And they will be right…..eventually.

Without a doubt the market will reverse because it always does. Prices move in waves and I will cover the psychology behind these waves in another CMU post. (Sign up for Free Email Alerts so you don’t miss it) Unfortunately the key to making money is timing those waves exactly right. This is where popular sentiment indicators often let us down.

“Too bullish” or “too bearish” are vague and subjective. There are quantifiable sentiment measures like AAII’s weekly sentiment survey, but it is far from comprehensive and it tends to jump around. Stocktwits measures real-time sentiment in its $SPY stream, but that only tells us what a very small and highly active group of traders thinks. Other tools look at option premium, but they are equally flawed. That’s because sentiment can sustain extreme levels for months, even years.

It is best to think of sentiment as a secondary indicator. It tells us when to start thinking about something, but it doesn’t tell us when to make a trade. It is dangerous to say we should buy every time a sentiment indicator goes under 30 and sell every time it goes over 70. That’s because a 30 can stay a 30 for months or fall to 25, all while the market continues to selloff. Buying a dip a month or two before the bottom can definitely be a traumatic experience.

On the opposite end of the spectrum, sentiment has been “overly bullish” almost this entire year. It started with Trump’s election and continued all year based on hopes of tax cuts. Anyone who sold early in the year because the market was “too bullish” missed out on a nice rally. And anyone who was foolish to short this “overly bullish” market had a very painful year.

The reason sentiment measures can stay elevated for so long is they often only measure a subset of traders. For example highly active traders that fill out weekly surveys. Or the options market. While these give us a good idea of what short-term traders think, it leaves out the opinions of 401k investors who don’t follow the market. These passive investor’s opinions change much slower and this year it was their gradual warming up to the benefits of tax cuts that allowed us to rally so consistently and for so long. Even though active traders were “overly bullish”, the wider pool of investors was only beginning to warm up. And it is buying that kept pushing us higher even though most sentiment measures told us we were topped out months ago.

I love trading against extremes in sentiment, but I need the price-action to confirm my trading thesis before I will stick with a sentiment based trade. If the market doesn’t act the way it is supposed to, I bailout quickly because I know how unreliable these signals can be. Don’t let a stubborn opinion about “too bullish” or “too bearish” lock you into a losing trade.

Jani

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